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Brian Fallow: SOE sale solution in search of a problem

26 Jan, 2012 5:30am

6 minutes to read

A mix of unknowns makes quantifying the gain of partial sale of the Government's power companies difficult, but independent evidence suggests as far as cash flow goes, there may be nothing in it. Photo / Simon Baker

Reports released by the Treasury just before Christmas provide further evidence the planned partial privatisation of the state-owned power companies is a solution in search of a problem.

It's something of an article of faith of the political right that state ownership will produce commercially inferior outcomes to private ownership.

But a comparative analysis commissioned by the Treasury's Crown ownership monitoring unit from Ernst & Young indicates instead that the boards and management of Mighty River Power, Genesis Energy and Meridian Energy have met their statutory obligation to run the SOEs as if they were private companies and, indeed, have run them pretty well by international standards.

Ernst & Young have benchmarked the profitability of the companies over the past 10 years, measured by return on invested capital, against a set of 27 companies mainly engaged in the generation and distribution of energy in Australia, New Zealand and the United States.

In the case of Mighty River, it was consistently in the top 25 per cent of the peer group, whether revaluations are included in the return on invested capital or not.

So was Meridian, except at the very beginning and end of the 10-year period.

Genesis was above the top quarter for most of the period when revaluations were excluded, but in the bottom 25 per cent between 2006 and 2009 when revaluations were included, reflecting the writing off of its big but ageing coal-fired plant at Huntly.

But Ernst & Young attach caveats to the international comparisons.

Inevitably there are differences that change things between jurisdictions in market structure and regulation.

And a New Zealand power company would need to earn a higher return on invested capital in percentage terms because it faces a higher cost of capital than its counterparts in the United States or Australia.

But the Ernst & Young work does at least suggest the planned move to a mixed ownership model fails the "if it ain't broke, don't fix it" test.

The Treasury has also released independent commercial valuations, by First NZ Capital in the case of Mighty River and by Macquarie for Meridian and Genesis, to provide a second opinion on the valuations the companies themselves provide.

First NZ Capital values Mighty River at $3.63 billion, which is $88 million less than its board does.

Macquarie's valuation of Meridian is just $31 million higher than the $6.5 billion the company came up with.

But it differs significantly when it comes to the Genesis view of its commercial value - Macquarie's $1.76 billion is $357 million lower than the board's estimate of $2.12 billion.

Genesis wrote up the value of its generation business by $456 million last year, largely reflecting its view of long-term wholesale electricity prices.

However, Macquarie also considered an alternative valuation methodology which arrived at a range of $1.75 billion to $2.1 billion, happily bridging the gap between its view and the company's.

The thing is that none of these numbers is Holy Writ.

Putting a forward-looking valuation on these enterprises is a task of fiendish complexity which requires the valuer to take a view on a daunting list of unknowns. They include questions such as:

* What will happen to growth in demand for electricity?

The industry, like everyone else, did not foresee the recession of 2008 and now finds itself with an excess of generating capacity commissioned on the basis of load growth forecasts that were historically plausible but, as it turned out, optimistic.

* What will the future of wholesale and retail power prices look like, and the important ratio between the two which differs from one company to another and over time?

* What will future costs be, including fuel and carbon and capital equipment?

* Will the amount of snow and rain falling in the hydro lake catchments be more or less than normal?

Rio Tinto has put the Tiwai Point aluminium smelter up for sale. Meridian has a contract with it that runs to 2013, assumed to be secure.

But were the smelter to close it would be a seismic event for the industry, reducing national load by 14 per cent at a stroke and requiring major transmission investment to get power from Fiordland to northern markets.

Clearly, with so many moving parts in the calculation there is scope for widely differing views of fair value for these enterprises.

The chances that the three key groups - taxpayers, investors and consumers - will all emerge from the sales process free of the suspicion they have been ripped off are just about zero.

So why is the Government so bound and determined to proceed? The fiscal arguments, after all, are weak.

No doubt the Government needs to reduce its debt. But it needs to do that the hard, old-fashioned way by curbing its spending.

Simply shrinking both sides of its balance sheet by (more or less) the same amount does nothing to improve its financial position.

In cash flow terms, there's nothing in it. Dividend forecasts from the SOE energy companies - Meridian, Genesis, Mighty River and Solid Energy - as consolidated by the Treasury average $449 million a year over the next five years.

Forty-nine per cent of that is $220 million.

Throw in $20 million for 23 per cent of Air New Zealand and the dividends forgone would average $240 million a year, 4 per cent of the $6 billion mid-point of what the Government hopes to get by selling.

Compare that with the interest bill it would have to pay on the $6 billion it would have to borrow, all else equal, to replace the sales proceeds forgone.

Rather than speculate about what will happen to bond yields over the next five years, let's just take what the Government paid on its debt over the past year, 5 per cent, which would be $300 million a year.

That's a difference of 1 percentage point between dividend yields and bond yields or $60 million a year.

That is so far within the margin of error for an exercise like this that, in the context of a $70 billion Budget or a $250 billion balance sheet, it is a wash and certainly not the solution to any fiscal problems.

True, the policy would reduce the Government's gross debt compared with what it would otherwise be, releasing capital for higher priority spending while avoiding the need to approach skittish offshore funding markets.

But there is an opportunity cost to that. The private sector money has to come from somewhere.

If "Mum and Dad" investors reduce their bank deposits, for example, to invest in the SOEs then, all else being equal, the banks will have to increase their offshore borrowing.

Alternatively there may be switch out of other forms of saving, including Government stock.

It is only if the privatisation process increases national savings that it will lessen the country's, as distinct from the Government's, reliance on offshore lenders.

It's a lot of trouble just to ensure some New Zealanders own more of these enterprises, while the rest own less.